Ramifications Of A Weakening Dollar

Economics:

The dollar has strengthened considerably in recent years, appreciating by about 33% in real terms since its trough in 1995. Although the dollar has weakened recently, the decline has, in fact, been trivial relative to the earlier rise. Nevertheless, the risk of a sharp dollar decline is worthy of considerations for four reasons:

The dollar is overvalued in terms of trade competitiveness.

The U.S. current account deficit is already significant and is likely to grow over the next 12-18 months.

A dollar decline would worsen the U.S. economy.

There is no easy, effective remedy that would necessarily halt such a slide.

The consequence of the strong dollar has been a loss of trade competitiveness and dramatic deterioration of the U.S. trade and current account balances. These imbalances are not a problem as long as foreign investors want to increase their holdings of dollar-denominated assets at an increasingly rapid rate. Dollar weakness would generate consequences for the U.S. economy that would reduce the attractiveness of dollar assets further.

The initial impulse created by a falling dollar is higher inflation and slower growth. A weaker dollar leads to higher import prices. In addition, there is more room for domestic producers to raise prices as competitive pressures from abroad moderate.

Eventually, a “declining dollar” would stimulate U.S. economic activity by improving U.S. competitiveness, but the lags are very long. It would probably take a year or more for a dollar decline to have a significant positive influence on economic growth.

A sharp dollar decline would prove very awkward for U.S. policymakers. For Federal Reserve officials, such a decline would worsen the trade-off between growth and inflation. If the dollar were falling sharply, this would increase the motivation to raise interest rates. However, whether this would save the dollar is unclear. If the Fed, in an effort to support the dollar, increases interest rates, it may cause investors to become more pessimistic about the U.S. growth outlook. Most likely, the Fed would be slow to react because the initial stages of dollar weakness may simply be a reversal of earlier dollar strength.

In summary, the initial effect of a significant dollar depreciation or gross domestic product growth would probably be negative. The main reason is that the real income of U.S. consumers would decline more than the rise in real income of U.S. exporters. Also, the impact of income on spending is probably larger for consumers than for businesses. The long-run impact would be significantly positive as the change in relative prices would induce foreigners to buy more U.S. exports and U.S. consumers to buy fewer imported goods.

Stock Market:

Since 1970, stock market performance is generally positive during periods when the dollar is declining. However, today’s stock market could potentially be more negatively affected by a weak dollar than in the past. To the extent that a weak dollar creates an outflow of foreign capital, foreign demand for U.S. stocks would diminish. Foreign investors directly hold about 11% of the U.S. stock market compared to about 6% in 1991.

Some industries benefit when foreign demand rises due to a weaker dollar. Soft drinks and Semi-conductors, for instance, have a long-standing dependence on exports for healthy profits, so a weaker dollar tends to lead to improving global sales. However, to the extent that raw materials are purchased locally, a weaker dollar can have a negative impact on the cost structures of companies with overseas operations. Therefore, companies with significant foreign sales do not necessarily benefit in a climate where the dollar is weakening.

Other industries that have not, at least in the longer-term, been affected by the changing tides of global demand include Retail Drug Stores, Broadcast and Cable, Casinos and Gaming, and Movies and Entertainment. Strong performance here is likely the result of a “flight to stable demand” brought on when dollar weakness leaves investors seeking defensive shelters.

One of the worst performing industries when the dollar is weak has been Automobiles. Isn’t a falling dollar supposed to be good for exports? This is not the case for automakers because foreign producers often drop their own auto prices to stave off any increase in demand for the lower priced U.S. autos. Also, Steel is among the unexpected historical laggards. The U.S. steel industry has difficulties competing against government subsidized foreign producers, even under the most favorable of circumstances.